Alibaba’s CEO and COO Resign Amid Scandal; Is this a Severe Blow to Confidence in China’s eCommerce Giant?

News came out of China early this week exposing a huge scandal at e-commerce powerhouse Alibaba.com Limited (HKG: 1688) which has led to the resignation of David Wei and Elvis Lee, the company’s CEO and COO, respectively. While neither exec is accused of complicity in widespread incidents of fraud, they were quick to step down and accept responsibility for not having prevented it.

According to the the company’s own press release the scandal concerns China Gold Supplier (CGS) customers that joined the Alibaba marketplace with the sole intention to “defraud global buyers” by offering “high-demand consumer electronics at very attractive prices, a low minimum order quantity and less reliable payment transfer methods” and then never delivering on the orders. The company determined that 1,219 CGS customers in 2009 and 1,107 CGS customers in 2010 engaged in this fraudulent activity and the average loss by buyers was less than US$1,200.

The fact that there are fraudulent suppliers on a B2B e-commerce platform is not surprising. All b2b and c2c marketplaces like Alibaba’s put in place procedures to limit such fraudulent activity. The whole purpose of the CGS classification is to add a high level of authentication and reliability to the participating suppliers.

Increase buyer confidence with a verified company profile, as over 85% of buyers prefer to do business with verified suppliers only. All Gold Suppliers on Alibaba.com must complete an authentication and verification process by a third-party credit-reporting agency before qualifying as a Premium Member, so this additional security measure helps you gain immediate trust as a legitimate company and serious supplier.

So the real scandal from this revelation has been “that about 100 sales people, out of a field sales force of about 5,000, as well as a number of supervisors and sales managers, are directly responsible in either intentionally or negligently allowing the fraudsters to evade [Alibaba's] authentication and verification measures and systematically establish fraudulent storefronts on the international marketplace.” In other words, the Gold Supplier program was compromised by Alibaba employees that worked with fraudulent suppliers to provide them the certification in order to improve their own sales performance by bringing in close to RMB40 million (US$6.1 million) in additional registration fees.

The company also announced the that Jonathan Lu, CEO of Tao Bao Holding Limited, an unlisted sister company in the Alibaba Group, and an EVP of the Alibaba Group, would take over as CEO immediately. He will also continue the responsibilities of his current positions at Taobao and Alibaba Group.

Besides the replacement of the top executives, the company also terminated all of the storefronts of the fraudulent suppliers and either fired or severely penalized employees involved in the deception. Investigations into the scandal will be ongoing.

Since the scandal broke there has been tremendous fallout about the future of Alibaba.com and its sister companies such as Taobao. Investors on the Hong Kong Stock Exchange, where Alibaba.com is listed, punished the company with a 12.5% decrease in its stock price since the scandal broke. In addition, despite claims that sister company Taobao did not have any imminent plans to IPO, the attention associated with this scandal may make it harder when they are ready to do so.

On Monday, after the scandal broke, Jack Ma, the Chairman of The Alibaba Group, issued an internal memo to his employees (aka – Aliren or “Ali people”) to explain what was happening. Here’s an excerpt from the email that was posted on All Things D:

Fellow Aliren:

As we have announced today, the B2B board of directors has accepted the resignations of B2B CEO David Wei and COO Elvis Lee. Additionally, former senior VP of B2B HR Kangming Deng has resigned his post as Chief People Officer of Alibaba Group in acceptance of responsibility and will be demoted to a different post.

Several months ago, we discovered that some of our B2B China Gold Supplier (CGS) members were suspected of fraudulent activity. What made it shocking was evidence indicating that certain members of the CGS sales team knowingly allowed, or in some cases even helped, these fraudulent companies join the Alibaba.com marketplace.

We formed a special task force to investigate the situation. According to the preliminary results of a month-long inquiry, we found 1219 CGS (1.1% of all Gold Suppliers) who joined in 2009 and 1107 CGS (0.8% of Gold Suppliers) who joined in 2010 were engaged in fraudulent activity. These fraudsters had joined the Alibaba.com marketplace for the sole purpose of exploiting the platform that we’ve labored to build up over the past 12 years to defraud overseas buyers. At the same time, the investigation confirmed that nearly 100 CGS sales staff knowingly allowed fraudsters to become CGS members so that they could “make their numbers” and receive commission income.

Any tolerance of this type of affront to business ethics and company values is a crime against the rest of our customers and Aliren who remain honest. We must…

Whether this will have long-term impact on The Alibaba Group portfolio companies seems unlikely to me. While the scandal validates claims by many that the Alibaba.com platform has been rife with fraud for some time, it also gives the company a chance to “re-boot” and promote the steps its taking to rectify the situation. One only needs to look at the scandal that beset China’s search engine giant, Baidu.com, Inc. ((ADR) NASDAQ: BIDU), which was accused of manipulating organic search results to reward or punish companies based on their advertising expenditures with the company.

After the company acknowledged its problems it implemented the Phoenix Nest ad buying platform, an update to its existing system that was meant to demonstrate greater transparency, integrity, and fairness in its business model. After some slowdowns leading up to the release of Phoenix Nest, the company has begun attributing traffic and revenue increases to the program.

[...] latest initiative by Alibaba.com is part of its process of rebuilding user trust following a huge scandal in February 2011 that revealed fraudulent China Gold Suppliers were being aided by company employees. The addition of real-name authentication will hopefully be [...]

[...] the wake of a major fraud scandal earlier this year at its sister company Alibaba.com Limited (HKG: 1688), the company makes clear that it adheres to very strong consumer protection policies. [...]